Consumer Debt/Credit Contracting at Rapid Pace

Consumer credit decreased at an annual rate of 5-3/4 percent in August 2009. Revolving credit decreased at an annual rate of 13 percent, and nonrevolving credit decreased at an annual rate of 1-1/2 percent.

Nonrevolving credit includes auto loans, and was boosted by the Cash-For-Clunkers program during August, yet seasonally-adjusted nonrevolving credit still decreased during August. Revolving credit includes mainly credit cards. Consumers are paying off credit cards at a furious pace.

It's time to re-post the Where We Are Now post from March.

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I thought it would be good to give just a 2-minute, off-the-cuff sketch of Where We Are, without many explanations (see previous posts for these). Just a quick bunch of thoughts.

After a 30-year, massive credit/debt boom aided by advertising, the ratio of American household indebtedness vs. income rose to levels similar to the peak in 1932 , and even doubled vs. incomes over 30 years. When the last easy-money extreme -- NINJA loans -- finally faltered, the bubble of credit began to reverse in late 2007, and house prices began their downward return towards normal. In response, people are trying to save for retirement since their houses and stocks are worth considerably less.

The change in consumer spending is likely to be semi-permanent (lasting, and only partially reversing), and that's for the people who have jobs. Meanwhile, jobs servicing the artificially high demand of the credit-bubble times are being lost, and that will be huge.

Rogoff and Reinhart's study of past financial bubbles shows it's likely that house prices will continue down for years more, and jobs losses are likely for years. The average GDP decline after such busts is 9%.

The Fed is acting more aggressively than ever before, yet how can extra credit availability matter when people everywhere simply choose to save? Consumers choose to save regardless, and businesses will choose to be conservative regardless of credit availability, since we all see the same reality. One way the Fed can do something meaningful is to manage to get mortgage rates under 5% and hold them there for a long time, thus freeing up more discretionary spending for many households after they refinance.

In short, one necessity to help prevent a Long Slump (near Depression-like) that lasts more than 3 years is by somehow creating effective incentives to start new kinds of industry and business to produce new kinds of products and services that people want and do not already have.

Obama may realize this in part, but it's not yet clear how well.

That's where we are.

.......................

(Extra note: The Administration and Congress should not lowball the incentives for new business and job creation when they legislate. There is a tendency to work on the margin (for instance Obama's 2008 idea of a $3000 tax credit for new jobs). We will need something much more powerful, such as a 20% subsidy in the first year on the first $1 million of domestic investment and/or payroll increases that create jobs on net, paid a year later based on payroll continuation, and this subsidy percentage gradually attenuating over 3 years, for instance. It's not at all hard to set up rules to prevent substitutions or other abuse of such a subsidy. I could do it in an hour, and so could many experienced businesspeople.)

The Other Shoe Begins to Drop

One thing was clear at the outset of this Debt Bubble Collapse.

Nations with huge trade surpluses are in much more economic danger than nations with trade deficits like the U.S.

Like the U.S. in 1930, leading exporters today stand to lose the most jobs with a collapse in world demand.

The possibility is continued cataclysmic collapse in trade, leading to massive downturns in GDP and jobs in the export leaders.

That's right, it's the most successful exporting powerhouses like Germany, China, Korea and Japan which are in the greatest economic danger. Much more so than the U.S.

Their only hope is to create serious domestic demand increases, which would require drastic plans to accomplish. Such plans are not visible, although China has taken a partial step.

It's not that no response at all has occurred. Germany did try a clever auto trade-in scheme for instance. China promptly developed a lending/building&infrastructure-boom, which isn't exactly consumer demand, but is better than nothing. But these, while helpful, are far from the real economic strength that would come for instance from China supporting its own growth via increasing Chinese consumer demand.

While China pressed the Keynesian stimulus button at least partly, Japan tried a new tack, Korea aimed green, and Germany begrudged a small stimulus inadequate for a nation where exports were 47% of GDP, the truly enigmatic picture has been Germany.

It only took a moment to guess why Germany was reluctant to try sizable deficit Keynesian spending (in proportion to the large downturn) months ago if you remember your history -- the hyperinflation of the Weimar Republic is their greater economic memory, not the Great Depression, which Germany quickly escaped.

But in recent months, as we watched job loss and panic around the world, the Germans seemed comfortable, busy shopping, unaffected. While German trade figures dropped precipitously, the mood in Germany seemed...chipper.

But it turns out there's a reason Germany defied economic logic for a while...

Marketplace points out why:

STEPHEN BEARD:"...rather than lay off large numbers of staff, German companies have kept them on, working a shorter week, often with a Government subsidy, in the hope of an early upturn....

SIMON TILLFORD:"The assumption that there will be a relatively robust economic recovery now looks pretty far-fetched, hence German companies are going to start laying off workers in large numbers over the next six months....

ANDREW HILTON:" ...If the U.S...bounces back, the German economy will bounce as a result...but, if the recession is prolonged in the U.S....we will see rising unemployment in Germany...focused in the export sector."

Could these strong, hardworking nations do something about their impending employment waterfall?

Sure.

But will they?

The Great Depression...and Now (updated 6-09)

While listening to Simon Johnson on Bill Moyer's Journal tonight, it struck me that the primary cause of the Great Depression, the main factor that deepened then prolonged the 1929-30 recession, isn't clear for many people. Near the end of the first segment in Moyer's program, Simon quips that economists will still be debating the Great Depression 50 years from now. While some may, I believe we can decipher these events in a way that will decisively end the general debate soon.

When I reflect on the hundreds of articles and blog posts I've read on the Great Depression and our situation now, and on my own evolving thoughts over the last two years, one fundamental economic process stands out in this grand worldwide train wreck. Let me illustrate this decisive force and its play within the complex string of events.

The 1929 recession came after a period of significantly increasing consumer installment and mortgage debt. When a growing stock speculation bubble continued in 1928, the Federal Reserve raised rates to slow the expanding stock borrowing. A recession began in the summer of 1929, which in turn helped destabilize the stock market bubble, leading to the October crash, which contributed to a reduction in demand and availability of consumer credit. As job losses mounted from the 1929 recession into 1930-1931, increasing numbers of bank loans went bad, which made more and more banks reluctant to lend just as more consumers became reluctant to borrow. Banks were taking in payments from those able to pay on their (still significant) debts, but not lending out much. This was a reversal of the run-up in credit, and the deflation which followed made debts harder to pay and the balloon mortgages unrefinanceable.

Various other effects further crimped demand and income: tax increases meant to gather more revenues from those still working, and trade wars which destroyed jobs in export industries.

As the job losses and fear mounted, many with jobs became more cautious in spending what they had. The circle of reduced spending leading to job losses which in turn further reduced spending drove the economy downward towards its essentials, its base, where what was being produced and sold were largely necessities. The slide continued under its own momentum.

By early 1933, this process had advanced far enough and long enough that the remaining demand and economy still in operation was the harder stuff of necessity. From this point, it should be no surprise that Roosevelt and Congress were able to quickly halt the downward drift and move things upward by ending the bank runs for the surviving (hardier) banks with new FDIC insurance, by widening economic rescue efforts, and by calming the people with fireside chats.

By 1933 the weak, frothy parts of the 1929 economy were all gone, and only the strong, hard base remained, ready to build upon.

Nevertheless, people had been trained into frugality by this time, and the debt burden was still significant. It would take years of gradual psychological gains in general confidence and the gradual development and appearance of new products and new wants to strengthen and broaden the economy so that more and more people could find work. Time was required to re-weave economic fabric exactly because so many who had lost jobs were also broke and had unpaid debts, so that even when they worked they were still miserly. World War II capped this process of slowly building up jobs and paying down debt, ending the remaining lack of demand and unemployment and accelerating technological innovation. By the end of the war, the U.S. was prepared in all essential ways for significant economic growth -- with increased general confidence and new technology ready to be put to work -- and only needed to be turned loose from wartime governmental control, which is exactly what happened next.

An analogy for America and its economy of 1928-1945 would be a story that starts with a drunk driver on a mountain road.

Drunk on overindulgence (stock speculation and debt) and driving too fast, our Driver careens into roadside trees at high speed (October 1929). But then worse, our hero tumbles down the cliff face (1930-31), taking further injuries, and finally goes without help or food for days (1931-33).

After what seems an eternity, our desperately injured Driver is finally rescued and put in hospital for a long, slow recovery (1933-1940). After gradually regaining health in this painful, slow recovery, our patient is then put into a strenuous, lengthy physical therapy program (WWII).

Finally, our Driver is released one day (1945), after what seems ages, now hale and full of strength and power, his confidence restored. He is a new man.

...

Will it take us 10 or 12 years to get back to a thriving economy?

Only if we have years of downward spiral, which is a threat due to the weight of household debts. And for the "thriving" part -- only if we undergo serious re-conditioning.

But our tumble down the cliff (joblessness) is being seriously fought and contested by the Fed and the Federal stimulus program, with multiple ropes.

Our modern Accident included air bags.

Rescuers are hard at work, bringing the Driver water and oxygen through the broken car window, hanging by ropes on the face of the cliff.

We may not need a 12-year recovery -- we have not yet suffered 1931-1933.

The ropes are creaking, and several have snapped or slipped off, but others have been hurriedly attached.

Nothing is clear yet at this point. ...Except, perhaps, that the old jalopy is totaled.

Nothing is certain. The car may yet go tumbling, or the ropes may hold.


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Update: Here is a good source of ongoing world economy graphs showing our progress vs. the Great Depression. It takes time for the effects of the stimulus program, and also of general confidence to show up in this kind of data. Perhaps by late summer we will have a better idea whether the world economy can deviate upward from the Great Depression trends we have followed so far.

How to Avoid a Lost Decade (updates ongoing 6/15)

(This post will be updated and/or revisited several times, due to its importance. I prefer to focus on the most important issues and stay with them until all the most valuable aspects are uncovered.)
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updated 2/19 -- refined loan idea
update 2/23 -- Japan article
update 3/3 -- some thoughts on comparing the U.S. and Japan (see "Update")
update 5/11 -- clarifying the broad effects of my proposed solution on national debt
update 6/15 -- loan repayment contingencies
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Martin Wolf brings up a crucial point about recovery from the end of a credit bubble (our big-picture economic situation).

Even if stimulus helps the situation, and banks are fixed so that they are able to make sound loans (instead of being overly restricted), that still doesn't get you out of the fallout of the credit bubble.

Readers of this blog have heard the suggestion we won't get back to a 1999 or 2005-like growth. Martin Wolf offers a explanation of the whole picture. In part, we can't get a rapid recovery because people are over-indebted, and trying to pay off their debts.

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute.* His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the overborrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan’s were, for years, as low as could be – were “pushing on a string”. Debtors kept paying down their loans.

Full article here. Martin goes on to clear up questions about Japanese stimulus and other aspects that have confused many commentators, and explains the huge risk in trying to reduce deficits simultaneous to consumers paying off their own debts. He says we face a very real danger of a lost decade in the U.S. and also for the world. I recommend reading this article.

Readers may recall I pointed out the upside in the inevitable fact that many consumers will use tax reductions to pay down their debt more rapidly (we've all heard the downside already) -- how this would lead progressively to increasing consumer spending over time. Each month would have some contribution of a modest increase in discretionary spending due to more people reaching the end of their credit card debt (to add into the sum of all other factors). These increases will accumulate into more economic strength over time versus the outcome without this effect.

So therefore, the modest Obama income tax reductions that help consumers pay off their debts more rapidly are supportive of economic recovery in complementary way compared to conventional Keynesian stimulus such as infrastructure spending. (Note: We need something more rapid to reduce total public+private debt -- see the key new idea proposed further below.)

In other words, while even larger government spending would be helpful, this alone will not cause an economic recovery until consumers have paid off enough personal debt or saved enough to feel good about spending more.

Further, once frugality becomes ingrained, an economy can become widely trapped in this new habit both by psychology and wage reductions, and finally by a need to secure retirement (see NYTimes article here).

Update:
Having considered differences between the United States and Japan for a while two conclusions stand out for me at this point. 1) No matter how you slice it, having a higher number of young people that aspire to buy houses, appliances, autos and such makes an enormous difference in net domestic demand, and thus employment, in the absence of large external demand for a nation's output. In other words, Japanese manufacturing suffers greatly now that the U.S. consumer is pulling back and its own domestic consumers do not have a large aggregate desire to buy in great quantity the products that Japan produces. The U.S. in contrast has a much higher proportion of young people, and thus will have a natural level of demand for new products, once some economic recovery arrives. Put another way, and this applies in lesser extent also in the U.S., older generations will not be able to maintain rising standards of living unless there are enough young people to help produce the products and especially to drive the economy (demand) upon which "wealth" depends. Of course...a true "standard of living" does not depend exclusively on an increasing quantity of stuff per capita consumed, but is a conglomeration of many factors and aspects, so we need to temper concluding too much about Japanese lifestyles from the outside.

The 2nd observation I have for now is that culture is a major and decisive factor in a nation's economy. Thus there are limits to how many parallels one can draw between the U.S. and Japan. Instead, we can only draw some broad points.

One crucial piece of a good "standard of living" in any case is that young families are in fact actually able to securely feed themselves, house themselves, and clothe themselves, and have some amount of free time in which to enjoy life. If an economy is so unstable as to prevent a significant fraction of young families from having any security at all, then this is indeed a profound and real failure.

Thus, back to the basic economic situation...

While the our new tax reductions are beneficial even when used in paying off consumer debt, and will gradually help us towards a recovery,...might there be another way to get there even faster?


What might help consumers pay off their non-mortgage debt faster?

Once we frame the question clearly like this, more effective economic recovery ideas can be imagined.

One possibility is to imagine a federal lending program (which has better long-term monetary and interest-rate consequences than deficit spending) for households to be used in a controlled way against existing personal non-mortgage debt. Consider for instance the 2008 $7500 first-time homebuyer loan, which carries 0% interest and is paid back at $500/year for 15 years, as an initial model. (note below on the profound difference of restructuring debt vs. pure deficit spending) This idea can be modified to fit our purpose here.

For example, this could take the form of an available up-to-$5000 (or even $7000) 0% interest loan to each taxpayer, repayable over 10 years through withholding or at tax time. Even the repayment terms could be responsive to the economy or job status of the borrower. For instance, the starting date for the 10-year repayment schedule could be delayed for each year during which the economy is still in recession or the individual is jobless, or the payments already underway interrupted during periods of joblessness.

A way to make this into a debt-restructuring stimulus would be to require all of the new loan must be paid against existing non-mortgage debt. For instance if an individual has $4700 in non-mortgage debt as of the effective date, they could then request a transfer of $4700 in debt. The U.S. treasury would then directly pay the creditors. The effect is similar to having a balance transfer to a 0% interest account on which one cannot make new charges (note this won't increase total public/private debt much even later -- credit card companies are much more conservative now about extending credit, widely decreasing credit limits instead of holding them steady.)

The point of this debt restructuring is the much better interest rates U.S. treasuries (which after all are tax obligations of all of us) must pay versus credit card interest rates. Households get a much lower interest rate effectively, and this will accelerate household debt reduction, and subsequent household spending recovery.

This would drastically change the debt-service loads that are weighing so heavily against the U.S. economy now. When an increased portion of the total spending power in the U.S. is left in household hands (instead of so much narrowly concentrated in wealthier investor and bondholder hands), the economic fabric of local economies (which in turn constitute the national economy) re-builds faster via the increased circulation of money in local economies.

The implication for U.S. treasury bond interest rates (a function of international confidence in the future U.S. economy) is quite different for a debt-restructuring plan (this idea) versus the outcome of pure deficit spending. Pure deficit spending, which increases the national combined public/private debt load, can be bad or good depending on it's effect in increasing future economic activity -- how well (or poorly) specific federal spending increases the future U.S. ability to pay back the increased national debt. In contrast, a debt-restructuring does not increase the combined public/private national debt load (after all the same households are responsible for both), but does increase economic activity by reducing interest rate burdens. This happens because a restructuring increases bond-investor confidence in a nation, corporation, or household as a good borrower. The net effect is less interest-rate burden (current and future) on U.S. households overall, in sum, on the combination of household debt and future tax obligations (on the same households).

Feeling more secure about debt payments and even about the whole national economy due to the plan, individuals would become less stingy with their discretionary funds, and thus a modest and increasing amount of additional discretionary spending will then flow into our dry-as-a-bone economy. As this stabilizes and supports the economy, job losses would be sharply lowered, and gradually a normal level of confidence would return, allowing a recovery.

Obama's Opening Statement at Press Conference

Barak Obama 2/9/2009

"Good evening. Before I take your questions tonight, I’d like to speak briefly about the state of our economy and why I believe we need to put this recovery plan in motion as soon as possible.

I took a trip to Elkhart, Indiana today. Elkhart is a place that has lost jobs faster than anywhere else in America. In one year, the unemployment rate went from 4.7% to 15.3%. Companies that have sustained this community for years are shedding jobs at an alarming speed, and the people who’ve lost them have no idea what to do or who to turn to. They can’t pay their bills and they’ve stopped spending money. And because they’ve stopped spending money, more businesses have been forced to lay off more workers. Local TV stations have started running public service announcements that tell people where to find food banks, even as the food banks don’t have enough to meet the demand.

As we speak, similar scenes are playing out in cities and towns across the country. Last Monday, more than 1,000 men and women stood in line for 35 firefighter jobs in Miami. Last month, our economy lost 598,000 jobs, which is nearly the equivalent of losing every single job in the state of Maine. And if there’s anyone out there who still doesn’t believe this constitutes a full-blown crisis, I suggest speaking to one of the millions of Americans whose lives have been turned upside down because they don’t know where their next paycheck is coming from.

That is why the single most important part of this Economic Recovery and Reinvestment Plan is the fact that it will save or create up to 4 million jobs. Because that is what America needs most right now.

It is absolutely true that we cannot depend on government alone to create jobs or economic growth. That is and must be the role of the private sector. But at this particular moment, with the private sector so weakened by this recession, the federal government is the only entity left with the resources to jolt our economy back to life. It is only government that can break the vicious cycle where lost jobs lead to people spending less money which leads to even more layoffs. And breaking that cycle is exactly what the plan that’s moving through Congress is designed to do.

When passed, this plan will ensure that Americans who have lost their jobs through no fault of their own can receive greater unemployment benefits and continue their health care coverage. We will also provide a $2,500 tax credit to folks who are struggling to pay the cost of their college tuition, and $1000 worth of badly-needed tax relief to working and middle-class families. These steps will put more money in the pockets of those Americans who are most likely to spend it, and that will help break the cycle and get our economy moving.

But as we learned very clearly and conclusively over the last eight years, tax cuts alone cannot solve all our economic problems – especially tax cuts that are targeted to the wealthiest few Americans. We have tried that strategy time and time again, and it has only helped lead us to the crisis we face right now.

That is why we have come together around a plan that combines hundreds of billions in tax cuts for the middle-class with direct investments in areas like health care, energy, education, and infrastructure – investments that will save jobs, create new jobs and new businesses, and help our economy grow again – now and in the future.

More than 90% of the jobs created by this plan will be in the private sector. These will not be make-work jobs, but jobs doing the work that America desperately needs done. Jobs rebuilding our crumbling roads and bridges, and repairing our dangerously deficient dams and levees so that we don’t face another Katrina. They will be jobs building the wind turbines and solar panels and fuel-efficient cars that will lower our dependence on foreign oil, and modernizing a costly health care system that will save us billions of dollars and countless lives. They’ll be jobs creating 21st century classrooms, libraries, and labs for millions of children across America. And they’ll be the jobs of firefighters, teachers, and police officers that would otherwise be eliminated if we do not provide states with some relief.

After many weeks of debate and discussion, the plan that ultimately emerges from Congress must be big enough and bold enough to meet the size of the economic challenge we face right now. It is a plan that is already supported by businesses representing almost every industry in America; by both the Chamber of Commerce and the AFL-CIO. It contains input, ideas, and compromises from both Democrats and Republicans. It also contains an unprecedented level of transparency and accountability, so that every American will be able to go online and see where and how we’re spending every dime. What it does not contain, however, is a single pet project, and it has been stripped of the projects members of both parties found most objectionable.

Despite all of this, the plan is not perfect. No plan is. I can’t tell you for sure that everything in this plan will work exactly as we hope, but I can tell you with complete confidence that a failure to act will only deepen this crisis as well as the pain felt by millions of Americans. My administration inherited a deficit of over $1 trillion, but because we also inherited the most profound economic emergency since the Great Depression, doing too little or nothing at all will result in an even greater deficit of jobs, incomes; and confidence. That is a deficit that could turn a crisis into a catastrophe. And I refuse to let that happen. As long as I hold this office, I will do whatever it takes to put this country back to work.

I want to thank the members of Congress who’ve worked so hard to move this plan forward, but I also want to urge all members of Congress to act without delay in the coming week to resolve their differences and pass this plan.

We find ourselves in a rare moment where the citizens of our country and all countries are watching and waiting for us to lead. It is a responsibility that this generation did not ask for, but one that we must accept for the sake of our future and our children’s. The strongest democracies flourish from frequent and lively debate, but they endure when people of every background and belief find a way to set aside smaller differences in service of a greater purpose. That is the test facing the United States of America in this winter of our hardship, and it is our duty as leaders and citizens to stay true to that purpose in the weeks and months ahead. After a day of speaking with and listening to the fundamentally decent men and women who call this nation home, I have full faith and confidence that we can do it. But we're going to have to work together. That's what I intend to promote in the weeks and days ahead. And with that, I’ll take your questions."

How Obama's Middle Class Tax Cut Will Save Jobs

Debate has intensified in the last few days about whether the Obama tax cut proposals in the stimulus package will be effective as a stimulus.

Among the majority that believe a stimulus package will indeed create and save some jobs on net versus no stimulus, the big issue is whether the stimulus size is enough to counter the large fall in consumer demand, and thus prevent higher and higher joblessness.

Keynesian stimulus in a nutshell is that government spending can increase demand in the economy to replace the fall in demand during a recession, saving jobs and creating jobs.

Several important side debates have been ongoing, and let's quickly dispose with a couple of those and get back to the main question of this post.

Objection A) Government spending does not create new jobs, since it relies on taxing or borrowing which in turn removes money or available investment and discretionary funds from the general economy -- simply shifting spending and investment from one place to another without a net increase.

For investing, this is called crowding out, and it certainly does happen when an economy is running at or near full steam, so that resources (machines, workers, money) are being fully or almost fully utilized, so that all new output of the economy requires new investment dollars. In that situation, private investment competes for those new dollars with government. But when an economy has much slack, as ours does now, so that more money is sitting in money market accounts and short term treasury bills, there is plenty of available money for government borrowing and investing, and still plenty left for any private borrowing and investing the private sector chooses. A similar situation applies to spending -- government spending does not compete so much with private spending during a recession -- concrete prices are down sharply, for instance, so government infrastructure spending on concrete will not be competing much with private demand for concrete to a level that would strain available output.

Objection B) Government spending/investing is top-down, and is thus less informed/knowledgeable than private spending/investing -- less effective at producing the goods and services people actually want for their lives and standard of living.

Example -- Joe would rather buy a new car instead of paying more taxes (or having future taxes) for more city bus service.

This again, as above, is true during a time of economic expansion, but is it true during a time of recession? Currently consumers who have jobs have sharply pulled back in spending, and are saving on the whole, which of course has led to a sharp drop in consumer demand, and thus more and more job losses. Consumers are choosing that they don't want as many consumer goods and prefer instead to pay off their credit cards, or build up their emergency fund.

As they save, more money is available for investing also, and some of it flows into safe US Treasuries. When the Government spends more now, it is not removing money from current consumer spending.

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Ok, now let's consider the Obama Middle Class Tax Cut (MCTC) as a stimulus....

We know that tax rebates of a size like that of summer 2008 are much smaller than average consumer credit card debt, and it's little surprise that much of that rebate was saved (or paid against debt), and yet helped the economy in a dramatic way not widely understood. (see link)

We can surmise that much of the coming MCTC will also be saved, at least for a while.

Until when?

Well, that's an individual level decision.

For someone who's been paying off credit card debt for example, they may continue paying it off at the same rate, or even add in the extra take-home pay from the tax cut and make even larger payments (saving all the tax cut). Until....

Until they have paid off the credit cards to zero.

Then what happens?

If you could imagine celebrating upon paying off a card or the last card, I bet you are like most people.

Might you go out to eat? Might you finally get your car repaired? Might you stop putting off that gym membership?

Yes, when consumers have less debt, they will respond by spending more, resulting in more jobs. Some will spend more, some less, but overall spending will increase in response to debt going down (or savings up). Poorer families will spend more, and the sad truth is many "middle class" families are practically poor.

Even while consumers spend less in 2009 with the new tax cut than they did in 2008, the issue is how much less. A tax cut will make a difference in consumer spending, immediately and progressively, both. Many jobs will be saved, adding to the positive effect of those newly created.

The Tax Rebate & TARP Worked Better Than Advertised Against The "Greater Depression"

One of several memes we've heard over and over now to the point of becoming conventional wisdom is that "the tax rebates didn't work".

Now, before you think I'm simply on one side of a partisan debate, let me say first I think taking sides itself a mental error that leads to further errors. I'm not on any side, unless it turns out Obama keeps doing everything right as we go along. I think most of the large publicized pieces of spending in the stimulus proposal are good ideas, and good together as a large package (though not bringing enough timely stimulus in 2009, see why speed matters). My view is that A) we need many different kinds of stimulus, both government spending and tax cuts, but that B) the stimulus, however large, will not suddenly bring us into a roaring recovery, that C) the deep recession is likely to last for years in terms of feeling like we are in a recession. In certain ways, all of this is beside the point. There are fundamental reasons why America cannot have another golden age where it is always wealthier than other nations. And worse, it's even likely that the unemployment and economic challenges we face cannot be fixed completely through most kinds of government stimulus -- that the temporary setup where China grew rapidly while holding down American inflation and interest rates (by providing cheap goods and exporting their excess savings to us also) has played out to an end, bringing back more normal economic turbulence. Only special, unique conditions like those of the 1950s or 1990s can create economic ease, and only temporarily. (I'll post about this interesting question later.)

But today, it's popularly understood we are under threat of another Great Depression. Some even speculate we may face a Greater Depression, due to the profound debt overhang weighing on our economy.

This housing price bubble was more pronounced than any before, implying a deeper fall and heavier than normal fallout. Arrayed against this danger is a more knowledgeable and aggressive Federal Reserve and Federal Government than in the 1930s.

Most people now understand there is a feedback loop of job losses increasing fear -- which in turn leads to further pullbacks in consumer spending, creating more job losses.

So the public at large widely understands that this recession could deepen and keep deepening without intervention.

And while the two sides of the debate argue about what kind of stimulus will "work", the real picture is both more complex and more simple than commonly presented by major columnists, news reports and economists.

It's more simple in that ultimately all the financial crisis is one simple process -- the inevitable fallout of an enormous decades-long world-wide credit bubble. Another element in the popular view of what is happening -- "letting Lehman Brothers fail worsened the crisis" -- is also false. The whole picture of a "credit crisis" worsened by "letting Lehman fail" presumes we could always have grown debt, ever more and more -- more mortgage debt, higher debt to income ratios, more consumer spending and less saving, without limit. Thinking that allowing Lehman to fail caused more crisis implies that if Lehman was saved, the crisis might pass, and things could continue as before the crisis. In this view, a "crisis" or "shock" happened which should and could have been contained. So the story goes, or went, with the support of some prominent voices.

Nevertheless, there is more and more recognition spreading that we had a more genuine problem of a true out-of-control bubble -- that the housing bubble is part of a more fundamental story.

The implication of having a real bubble is that it will indeed eventually burst and collapse, and that falling house prices are not just caused by foreclosures or psychology alone -- are not merely a by-product of some other chance financial events.

Saving Lehman Brothers would have been like patching one significant hole in a slow motion bursting bubble -- it would not stop other from holes opening and growing in the ever thinner bubble surface.

So the story is more simple than often portrayed -- we ran up debts much faster than our average incomes grew, leading to an inevitable hitting-the-wall moment.

By late 2004, there were no actions by the Fed, by the Federal Government, by regulators, by anyone, that could have made any difference. House prices had already become out of reach of average families with conventional mortgages in too many places.

If it hadn't been New Century Financial hitting the wall first, it could have been American Home Mortgage Investment Corp. If it hadn't been Bear Stearns collapsing before Countrywide, it would have been Countrywide collapsing before Bear Stearns.

If Lehman had been saved, at you and your children's expense, instead of at the expense of various investors, that would not have saved Washington Mutual (as an independent bank), IndyMac, Wachovia, Merrill Lynch, etc.

One of the more disturbing political processes I've seen up close is the evolving political story of the TARP. At this point the story has evolved to say the initial phase of TARP under Hank Paulson failed and was opaque. But Paulson originally presented TARP as a way to stop the ongoing crisis of banks failing and our financial system appearing in danger of collapse. This was not something that could be easily talked about -- even if more Congressmen understood the real picture, it tends to increase panic for many leaders to talk of most well-known banks failing. Instead Paulson had to warn simply of a general financial crisis intensifying. TARP, then, was easy to re-define into the ultimate political football. When Paulson flailed about at first due to the impossible contradictions of his initial plan of buying bad mortgage securities, and then later finally followed the mainstream advice of most economists to inject funds directly into banks -- the plan that was actually used -- he gave a characteristically brief announcement, perhaps presuming it would be understood.

But while his announcement made sense to economists and well-read followers of the situation, how many average people understood the whys and hows of the new plan? While Paulson efficiently and effectively shored up the surviving banks -- and did so openly and in full view -- it seemed to me everyone would be pleased the best possible plan had been enacted. The best possible outcome to that moment had been found.

But Paulson's actions were subsequently portrayed as opaque ("lacking transparency") and against the will and intent of Congress!

I wonder if many of our elected representatives realize that many average people are not fooled at all by the political rhetoric. Many more people than they realize are quite aware this was the Big One, and more banks were heading to the chopping block. More people than they'd guess have paid attention to the fact the big bank failures stopped after TARP, at least those with names everyone knew, the kind that kept everyone on edge.

The initial TARP money stopped the accelerating large bank failures (Washington Mutual and Wachovia were the last for a while), and reduced the panic, just as it was proposed to do.

TARP was initially proposed to "stabilize the financial system." TARP indeed did so, to the extent possible with that amount of money. But "stabilize the financial system" is too vague a term it turns out, and has been re-defined quite easily to mean things other than what close observers understood.

Often we'll hear a bit on a newscast of someone who wonders why TARP didn't stop the financial difficulties entirely. Some even believed TARP was meant to also save homeowners near foreclosure. This was certainly a communications mess.

The initial TARP was successful in a sense that mattered. A panic that threatened to escalate to complete collapse of all large banks was averted, along with the psychological damage that would have added against already weakening confidence.

TARP so far has been similar to strapping parachutes onto the passengers (banks) falling out of the disintegrating airplane of banks-that-took-risky-bets.

Those with parachutes are still drifting downward of course, but for now they are still breathing. Some banks receiving funds weren't in that shaky airplane, but rather stood safely on the ground, with few risky bets, and are in far better shape.

Ideally those sounder banks could actually buy out the weaker, poorly-managed banks at low prices, resulting in the best possible outcome for the nation.

But some in Congress actually objected to the beneficial effect of well-managed banks using TARP funds for acquisitions!

Does it occur to many in Congress that their political rhetoric is part of why the level of trust for Congress is so low? Even when we don't know exactly what the political misdirections are, we intuitively sense we often aren't hearing the real story.

Much of Congress played the blame game -- trying to make it appear the other partisan side was responsible for what few wanted to admit was inevitable.

It's estimated that American banks would need more than $1T (that's trillion, and some estimate more than $2T) to be effectively re-capitalized to the level of being able to do significant lending without worrying about failing in the next few years. (see George Soros on this)

Why so much? Because the realistic losses from the credit bubble (mortgages, credit cards, commercial real estate lending, etc) are expected to be this much or more when we aren't pretending things are better than they are. But the jobs of the Fed chairman, Treasury Secretary, and other public officials are to instill confidence. They must acknowledge things are only as bad as we can see in the rear view mirror, and by the way -- don't panic.

The gigantic losses of banks and across the economy are the result of the end of a decades-long credit bubble.

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So....the tax rebates of summer 2008... Seems like a while ago, doesn't it?

Consider this graph from the Minneapolis Fed of The Recession in Perspective (our current recession is in red):



Notice something?

Yes, it seems this recession didn't drop off as steeply in its early months as normal. During the Summer of 2008 (months 5-8 in the graph), when things should have deteriorated more rapidly....the pace of the downturn was somehow slowed....business failures were slowed, bankruptcies were slowed, bank withdrawals (runs) were slowed, mortgage defaults were slowed, housing sales held up a little better....

What we know is the powerful recession we are in acted like a mild recession for many months, quite different from the typical pattern.

Did the tax rebate anticipation and arrival hold off the real power of this recession for many months? If so, did this slowing of the downturn help the "crisis"?

Well, the recession, like all recessions is in part psychological, and depends on confidence. The crisis is in part fear, and fear is the most powerful force in it, able to stop consumers, businesses, banks and jobs in their tracks.

Fear tends to feed on itself. The unusual staying power of confidence in the first 7 months of the recession held off a lot of effects. By slowing the downturn, the level of fear was held lower than it would have been and the "crisis" unfolded more slowly, giving the Fed and the Treasury and the FDIC more time to plan and act and learn.

We know the powerful driver of the recession is the collapsing housing bubble, and the associated consumer debt bubble and commercial real estate bubbles. The gasoline price spike added a powerful drag during the summer, and without rebate checks to offset the high prices, would likely have collapsed consumer spending much faster during the summer. The other powerful factor in any recession is the level of confidence. Consumers felt more confident for many months than is typical in a strong recession like this one.

Why? Well confidence is a combination of expectations and news and popular stories about what is happening. Consumers were told the stimulus was coming and it was thought it would help. Both the tangible reality of extra cash in our pockets and the belief it would help buoyed confidence.

The Tax Rebate of 2008 was the cause of the gentleness of this recession for months, in spite of the other huge forces that would make it a powerful recession, as is now evident.

We are also told the tax rebate failed because most of it was saved.

Consumers, instead of spending like nothing was happening, chose to pay down part of their credit card debts or save a good part of their rebates. Because they saved more, they've felt a little less pressure and a little safer ever since (than they would have at without that extra savings). Because we all have a little more money at hand still, it's likely we choose to eat out or buy discretionary items just a little more often than we would otherwise.

Put another way, as we have cut back spending, we haven't cut back as much as we would have without that extra in our pockets (or lower card balance).

Do the particular theoretical "multipliers" for different categories of stimulus spending favored by those opposed to tax cuts measure the effect of reducing fear and adding residual extra spending months later? If your guess is no, I bet you are right.

Having saved more, many of us now are spending a little more, supporting each others' jobs just a little better than we would have without that summer 2008 rebate.

Now....do you really think the Tax Rebate of 2008 didn't work?